How is Inherited Property Taxed?
How is inherited property taxed?
You’re here because you need help understanding the tax consequences of inherited property.
I’ve got you. I’m Katherine. I’m a CERTIFIED FINANCIAL PLANNER®, a financial advisor for inheritance, and a fellow inheritor.
Keep reading for the ESSENTIAL guidance you need to understand the tax consequences of selling inherited property and my advice for building a tax-efficient plan to manage or sell inherited property.
Posted on September 26, 2024 by Katherine Fox.
How is inherited property taxed?
Most people don’t have any idea how their inherited property will be taxed, before or after they sell.
You’re trying to learn an entirely new knowledge set while you’re grieving and managing a stupid amount of other death-related details.
You may have considered looking for an inheritance financial advisor to help.
In the meantime, you’re stuck with more questions than answers.
You might be wondering:
How is inherited property taxed?
How is inherited property taxed when sold?
Do you pay property taxes and income tax on inherited property?
Does the step-up in basis affect the taxation of inherited property?
Did I get a step up in basis on my inherited property?
Does the primary residence tax exclusion apply to inherited property?
What are tax considerations for inherited rental properties?
What are the tax consequences of selling inherited property with multiple owners?
Luckily, you ended up here.
Keep reading for the 8 ESSENTIAL things you need to know about how inherited property is taxed when sold.
You’re closer than ever to finding answers to your questions and moving forward with a tax-efficient plan to sell, manage, and grow your inheritance.
I’m Katherine. I’m a CFP® and a financial advisor for inheritance.
I’m here to help you through this journey, whatever your needs are.
If you’re trying to get up to speed, check out the 20 Terms Inheritors Need to Know or How to Talk to Your Parents About Their End-of-Life or Estate Plan.
And if you’re deep in the weeds and don’t know what to do next, schedule a FREE consultation to see how I can help you build a tax-efficient plan to manage or sell your inherited property
1.lHow is inherited property taxed?
The taxation of inherited property depends upon the state in which the inherited property was located.
Taxes may be due as an estate tax paid by the deceased person’s estate or as an inheritance paid by you as an estate beneficiary.
There are two types of estate or inheritance taxes that beneficiaries need to understand:
Estate Taxes
Estate taxes are paid by the estate itself. They are not the responsibility of estate beneficiaries.
Inheritors should consider both Federal and state estate taxes.
As of 2024, most estates are not subject to Federal estate tax. The Federal estate tax exemption limit is over $13 million for an individual and $26 million for a married couple.
This limits Federal estate tax consideration to the wealthiest families, with the caveat that these rates are scheduled to sunset back down to ~$7 million per individual / $14 million for a married couple in 2026. This leaves room for many more families to get snagged by an unexpected Federal estate tax bill.
State estate tax on inherited property is due based on the state where the inherited property was located, NOT the state where the person who lived died.
12 states and the District of Columbia have estate taxes. Tax rates and exemption amounts vary by state, with some states pegging their exemptions to the Federal estate tax rate and other states (like Oregon) with exemptions as low as $1 million.
State Inheritance Taxes
Inheritance taxes are paid by estate beneficiaries. They are not the responsibility of the estate.
State Inheritance tax on inherited property is due based on the state where the inherited property was located, NOT the state where the person who lived died.
6 states have inheritance taxes. All six of these states exempt spouses. Some states also fully or partially exempt immediate relatives.
8 ESSENTIAL things you need to know about how inherited property is taxed
Keep reading to get educated and ensure you’re making the best long-term decisions when evaluating a plan to keep or sell inherited property.
2. How is inherited property taxed when sold?
Whether you pay capital gains tax on inherited property depends on what you do with the property and how its value changes after you inherit.
Inheritors should remember that there is no immediate capital gains tax due upon inheritance. The transfer of ownership due to inheritance is not a taxable event.
How your inherited property is taxed when sold depends on the cost basis of the inherited property you received.
The cost basis is the amount that a property was purchased for, plus any improvements made to the property over time.
For example:
If I purchased a house in 2001 for $200,000 and made $300,000 worth of improvements, my cost basis in that property is $500,000.
If I decide to sell that house in 2024 when the price hits $1,000,000, I will have realized $500,000 in capital gains and may have to pay taxes on that $500,000 of realized gains.
These gains could be reduced/eliminated if the property was my primary residence.
Most inheritors, however, will receive a step-up in basis on their inherited real estate. This step-up in basis will affect the tax treatment of inherited property and is discussed in further detail in the next section.
Before moving on, it is crucial to note the tax rates inheritors need to understand before selling inherited real estate.
In normal circumstances, when selling an appreciated asset like inherited property you will be subject to different tax rates depending on how long you have held the asset:
Short-Term Capital Gains
Short-term capital gains are assessed on assets that are sold after being held for less than one year. Short-term capital gains tax rates are equal to income tax rates.
Long-Term Capital Gains
Long-term capital gains are assessed on assets that are sold after being held for one year or more. Long-term capital gains rates are lower than income tax rates, with the highest rate being 20% versus a top bracket of 37% on the income tax schedule.
When selling inherited real estate, this distinction does not apply. Your holding period is ALWAYS considered to be long-term.
Let's use another example:
My grandmother purchased a house for $500,000 one month before she died.
I inherited that house two months later. In the meantime, the local real estate market has boomed and my inherited house is now worth $1,000,000.
Even though the property has only been held for two months and one day, if I sell it, the gain will still be treated as long-term capital gains because I inherited the property.
If, instead my grandmother had stayed alive and sold the house herself two months later, she would have been responsible for paying short-term capital gains on her $500,000 sale proceeds.
3. Do you pay property taxes and income taxes on inherited property?
As a new owner of inherited property, you are responsible for paying all property taxes due on that property. You will also be fully responsible for paying taxes on any income that property may generate.
Property taxes
As the new owner, you are immediately responsible for paying property taxes. You may owe that tax bill before you even make a decision about whether you will keep or sell the property.
Inheritors also need to be aware that a transfer via inheritance could trigger a reassessment of a home’s value for property tax purposes and significantly increase the amount of taxes due annually.
Property tax is an ongoing expense that must factor into an inheritor’s decision to keep or sell inherited property. Even if a home is paid off, an annual property tax bill for tens of thousands of dollars might force the sale of inherited property or require inheritors to generate rental income to cover costs.
Income taxes
Inheritors are responsible for paying all income taxes due on inherited property that generates rental income. There are many specific income tax considerations for rental properties, which are discussed in a later section.
“Inheritors should remember that there is no immediate capital gains tax due upon inheritance. The transfer of ownership due to inheritance is not a taxable event.
How your inherited property is taxed when sold depends on the cost basis of the inherited property you received.”
4. Does the step-up in basis affect the taxation of inherited property?
The step-up in basis is a significant tax benefit for inheritors and one of the important concepts to understand when dealing with inherited property.
Here's a detailed look at how it works:
The cost basis of most inherited property is "stepped up" to its fair market value at the date of the previous owner's death. In some cases, an alternate valuation date six months after the date of death can be used if it results in a lower estate tax.
The step-up in basis can significantly reduce or eliminate capital gains tax when inheritors sell an inherited property. It essentially wipes out any appreciation that occurred during the deceased owner's lifetime for tax purposes.
For Example:
Your parent bought a house in 1990 for $200,000. Over the years, they made $700,000 in improvements, bringing their cost basis to $900,000.
When you inherit the house in 2024, it's worth $2,500,000.
Your new basis is $2,500,000, the fair market value of the house as of your parent’s dead of death.
In most cases, you do NOT inherit your parents $900,000 cost basis.
If you turn around and sell the house for $2,500,000, you will owe no capital gains tax on the sale.
Key considerations for the step up in basis:
It is crucial to get a professional appraisal of your inherited property's value at the date of death to establish your stepped-up basis and protect yourself against a potential IRS audit.
If you keep the house, any capital improvements you make will be added to the house’s basis. Keep careful record and receipts for these improvements.
Exceptions
Inheritors who owned property jointly with the deceased person may not get a full step up in basis. Some forms of property ownership do not receive a full step-up in basis. This depends on how the property is titled and in what state the property is located.
Assets inherited through irrevocable trusts will not receive a step up in basis.
5. Will I get a step-up in basis on inherited property?
Most inheritors will receive a step-up in basis on inherited property.
There are two primary exceptions to this rule:
Assets inherited through an irrevocable trust do not get a step-up in basis
If the person you inherited from set up an irrevocable trust to hold assets before they died, any assets you receive through that irrevocable trust will NOT get a step up in basis.
Irrevocable trusts are often used as a way to get money out of someone’s taxable estate. When an asset is placed in an irrevocable trust, its value is frozen and it is considered to be outside of a person’s estate.
This is incredibly useful for estate tax planning purposes, as it presents an easy way to remove appreciating assets from the estate tax calculation.
When you inherit one of these assets, however, you will inherit the asset's original cost basis. In the vast majority of cases, you will not receive a step-up in basis on assets inherited through an irrevocable trust.
Assets inherited through title transfer may not get a full step-up in basis
If you inherit property via a title transfer (for example, you are listed as joint tenants on a property and the other joint owner dies) you may not receive a full step-up in basis on the property.
For non-spouse beneficiaries, you will only receive a step-up in basis on the percentage of the property owned by your co-owner.
For example, consider that you and your dad purchased an investment property for $100,000. Your dad paid $75,000 and you paid $25,000 and you hold the property as joint tenants with right of survivorship.
When your dad dies, the property is worth $1,000,000.
You don’t get a full step-up in basis to $1,000,000. Instead, you get a step up in basis for your dad’s percentage of the property. Your new basis is $775,000 (your dad’s stepped-up basis of $750,000 + your original basis of $25,000).
6. Does the primary residence tax exclusion apply to inherited property?
Many inheritors are familiar with the primary residence tax exclusion when a home is sold.
You can exclude up to $250,000 of capital gains ($500,000 for married couples filing jointly) from the sale of a primary residence.
The exclusion requires that you have owned and used the house as your primary residence for at least 2 out of the past 5 years leading up to the sale.
Note that the time a deceased owner lived in the property does NOT count towards your ownership and use tests.
Your holding period for inherited property starts on the day that you actually own the property.
For example:
If you inherit a home worth $1,500,000 and live in it for a year and a half before deciding to sell. During that time the house appreciates to $2,500,000. If you decide to sell at that point, you would NOT be eligible to exclude any gain from the sale of the house via the primary residence gain exclusion and could owe capital gains tax on that $1,000,000 of appreciation.
7. What are tax considerations for rental properties?
Inherited rental properties come with their own set of tax implications.
Here's what you need to know:
Depreciation
Rental property depreciation is a tax benefit that allows you to deduct the cost of a rental property over a set period.
For properties that receive a step-up in basis, inheritors can start a new depreciation schedule based on the stepped-up value of the property at the time of inheritance.
Note that when the property is sold, you may owe depreciation recapture tax.
Passive Activity Rules
Rental real estate is generally considered a passive activity for tax purposes.
If you actively participate in managing the rental, you may be able to deduct up to $25,000 in rental losses against your ordinary income.
Otherwise, rental real estate income is treated as regular income on your tax return, and rental real estate losses can only be deducted against your rental real estate income.
8. What are the tax consequences of selling inherited property with multiple owners?
When inherited property has multiple owners, the tax situation can become more complex.
This often happens when siblings inherit their parents' home or when a property is left to multiple beneficiaries.
Here's what you need to know about property inherited jointly with siblings:
Basis Allocation
Each owner’s basis is determined based on their share of ownership. For example, if two siblings each inherit ½ of a $2 million dollar house, their basis would each be $1 million.
Capital Gains
Each owner is responsible for paying capital gains tax on their share of gain from the sale.
In the previous example, if the house sold for $2,500,000, each sibling would be responsible for paying capital gains tax on $250,000 worth of gain.
Each owner reports their share of gain own their own individual tax return.
Buyouts
If one owner buys out multiple owners, it is treated as a sale for the owners who are being bought out. In the same previous example, if one sibling bought out the other for $1,250,000 the sibling who sold their portion would report a $250,000 capital gain.
Inheritors should remember that you cannot force someone to own property they don’t want to own. If one sibling wants to force a sale of inherited property, the other siblings will be required to buy them out or sell the property, regardless of the tax consequences.
If you’re looking for help deciding whether to keep or sell inherited property and trying to figure out the tax consequences if you sell inherited property, reach out and schedule a call.
Sunnybranch is an inheritance wealth management firm, and we help clients like you answer these questions every day. I’d be honored to see how we can help you make a plan to use an inheritance to build a plan that works for YOUR future.
Let’s take the next step together
Understanding how your inherited property will be taxed before or after a sale is not easy. Inheritors can encounter a wide variety of different situations requiring knowledge and finesse to manage. If you need more help, you can download The 20 Inheritance Terms You Need to Know, or reach out to Katherine Fox, CFP® and CAP®, a fiduciary, fee-only financial planner to learn how Sunnybranch can help you build a plan to manage, grow, and protect your inherited investments.
